The Financial Crisis in Asia
Testimony before the Subcommittees on Asian and Pacific Affairs, and International Economic Policy and Trade
International Relations Committee
United States House of Representatives
It is an honor to be invited to testify before this joint meeting of these Subcommittees. I will organize my remarks today into three parts: the origins of the Asian financial crisis, the prospective impact of events in Asia on the US economy, and lastly, the implications of these developments for the architecture of the international financial system. The main points of this testimony will be that
- Events in Asia will slow US economic growth, and increase the US trade deficit on the order of $50 billion in the medium-run, with most of this increase generated by trade with Japan and South Korea. The effects will be experienced unevenly across the economy, however, with sectors such as light manufacturing experiencing declining output and employment, while sectors such as real estate and construction will grow.
- Growing trade deficits may increase trade tensions between the US and its trade partners, posing serious challenges for US policy.
- In the short-run, we have little alternative but to bolster the International Monetary Fund, flawed though it may be.
- In the longer-run, the creation of a new insurance-oriented organization, together with a reorganization of the Bretton Woods institutions, would be advisable.
Origins of the Financial Crisis
Without going all the way back to Genesis, one can identify four principal causes for the current financial crisis:
Exchange Rate Misalignment. Beginning in 1985, the Japanese yen began a rapid appreciation against other currencies, particularly the US dollar. As the relative cost of production in Japan rose, Japanese firms reacted by moving production offshore, mainly to South Korea and Taiwan. To counteract this shock to the domestic economy, Japanese authorities pursued an aggressive policy of monetary expansion. The result was an asset price bubble in Japan and massive capital inflows into South Korea and Taiwan. By the late 1980s, these two economies came under similar pressure to appreciate their currencies, with similar results: aggressive monetary expansion, asset price bubbles at home, and large capital outflows — this time principally to Southeast Asia.
Weak Financial Institutions. An important problem was that this capital was flowing into fragile, bank-centered financial systems. These financial systems were fragile for two reasons. Developing countries (including those in Asia) exhibit more volatility in macroeconomic aggregates and financial market indicators than larger, more diversified, developed economies. At the microeconomic level this hampers risk assessment and at the macroeconomic level creates greater vulnerability to economic shocks.1 These countries tend to have more institutionally concentrated financial systems than developed countries (i.e. fewer banks account for a larger share of lending), and these institutions themselves tend to hold less diversified portfolios than their counterparts in developed countries. This could be thought of as a problem endemic to developing country financial systems.2
In Asia, these latent disadvantages have been exacerbated by a variety of policy errors. In a number of countries, authorities permitted the development of serious asset-liability mismatches: banks financed long-term domestic lending through short-run foreign borrowing. Involvement by foreign financial institutions (which could have partly offset the lack of system-wide portfolio diversification noted above) was discouraged. Finally, in a number of countries the financial system was politicized: capital was channelled to politically preferred borrowers, and financial decisions were strongly influenced by non-economic considerations, including outright corruption.3
Export Slowdown. Such practices may be sustainable as long as the rate of economic growth remains high, as financial institutions compensate for the low effective rate of return on loans to these preferred borrowers with high rates of return on other loans. However, if the rate of growth slows, the bad loan drag begins to inhibit the ability of banks and non-bank lending institutions to supply credit to the economy. This is what transpired in a number of Asian economies last year as some key export prices declined (computer chips, for example). The slowdown in export revenue led to expectations of reduced corporate profits and to a decline in equity prices. First domestic residents, followed by foreign investors, began moving money offshore in search of higher returns, contributing to exchange rate depreciation (in countries that float their currency), or alternatively, putting pressure on the exchange rate peg (in countries that peg to a foreign currency such as the dollar). (A number of commentators have attributed causation to the Chinese devaluation of 1994. Close inspection of the facts would suggest that the Chinese devaluation was at most a contributing factor, not the primary cause of the weakness in export prices.)4
Moral Hazard. Lastly, it has been argued that previous financial rescue packages, most notably the one extended to Mexico in 1995, contributed to the current crisis by creating a moral hazard: investors would not exercise due diligence since they would expect to be bailed out in the case of default. The logic of this argument is unassailable though its force is questionable. As I can testify from personal experience, equity investors in Asia (as distinct from lenders) have experienced a significant reduction in the value of their investments. Moreover, while it is true that the spreads between Asian and US sovereign debt narrowed considerably, this occurred largely in the first half of 1997 — not in 1996, as one would expect if lenders were motivated by moral hazard considerations. Rather than moral hazard, it appears that lenders simply got it wrong in 1997.
Impact on the US
Conventional wisdom is that the events in Asia will reduce US growth by 0.5-1.0 percentage points relative to baseline over the next two years or so. My own modeling work indicates that the increase in the US trade deficit could be on the order of $50 billion, most of this being generated by trade with Japan and South Korea.5 The impact will be felt quite differently in different sectors of the economy, however. Import-competing sectors such as light manufacturing are likely to experience declines in output and employment. Obversely, non-traded, interest-sensitive sectors such as real estate and construction should benefit. One might think of this situation as similar to the mid-1980s when the term "Rust Belt" entered the popular lexicon, while the "Sunbelt" experienced a construction boom (though compared to the mid-1980s, the impact of the events in Asia will only be one half to one third as large).
The increase in trade deficits is likely to worsen trade tensions with countries such as South Korea. As the world's sole superpower, US leadership will be crucial to constructively resolving this crisis. Any move to close the US market in response to the rising deficits would set a horrible example for the rest of the world. With this mind, I attach a copy of the "Kindleberger Spiral" named after its originator, Professor Charles Kindleberger.6 This diagram graphically illustrates the implosion of world trade which occurred between 1929-1933, as countries (including the US) pursued the "beggar-thy-neighbor" policies of protection and competitive currency devaluation. The point is not that 1998 is 1929. Rather, the lessons are that there are links between trade and finance, and policy can have an enormous impact on outcomes.
The International Monetary System
The International Monetary Fund (IMF) and World Bank (collectively the Bretton Woods institutions) were established in 1945, fifteen years and one world war after the world spiralled into Depression. The IMF was established to act as a central bank for central banks — a lender of last resort — and to codify the rules of international finance. Under IMF leadership, current account convertability is nearly universal — anyone can take their domestic currency, exchange it for foreign currency, and purchase foreign goods and services. This simple exchange, which we now take for granted, was not the world of Kindleberger's spiral — a world in which central banks had to negotiate bilateral exchange agreements before the simple transaction described above could occur.
These accomplishments should not be underestimated. Nevertheless, the international financial system has changed enormously from the fixed-exchanged rates and capital controls of the first half of the Fund's existence, and it is fair to ask now whether the existing institutional framework is optimal for today's world. The answer is surely "no."
The Fund has become almost entirely irrelevant with respect to industrial developed countries in an era of free capital movement and floating exchange rates. Its relevance now is limited almost entirely to developing countries and those countries making the transition from central planning to the market. With respect to these latter groups the IMF has shown some ability to encourage stable macroeconomic policies. Unfortunately, the crises that currently grip Asia are less about government budget deficits, and more about the misuse of domestic financial systems. It is not obvious that the Fund has any particular expertise in this area.
Likewise, the Fund's sister institution, the World Bank, has drifted steadily away from its original mandate as a bank for reconstruction of the developed economies devastated by the Second World War, to an institution charged with promoting development in hitherto undeveloped countries primarily through long-run infrastructural lending, to in the Asian crisis, providing balance of payments support to an OECD member country (South Korea). With the Fund working almost exclusively with developing countries, and the World Bank now in the business of balance of payments lending, the division of labor between the Bretton Woods twins would appear to have become blurred beyond all recognition.
Thus we are faced with a situation in which there is no institution designed for the major problem we face, instead we have two institutions, the Bank and the Fund, designed for another era, whose missions are increasingly indistinct.
On the substantive question of what to do about the financial crises, I would argue that we need to move toward more market-based solutions. George Soros, for example, has suggested creating a publicly-funded international insurance organization.7 The basic idea is that the organization would provide lending insurance, provided that the borrowing countries met certain guidelines. Lenders could then buy insurance against default. The idea is that "good" borrowers — those with transparent financial systems — would be able to borrow lower rates, while lenders could avail themselves to insurance. The attraction from the standpoint of lender national governments is that the explicit and transparent insurance mechanism would make it easier for them to say "no" and avoid bailouts, if borrowers and lenders chose not to participate in the insurance scheme.
There is no reason that such an insurance mechanism should require public funding. Borrowers would face an incentive to participate in order to obtain cheaper loans, and lenders would face the same incentives to purchase insurance that any economic agent confronts when facing risk. In principle, such an arrangement could be self-financing.
Some have argued that an insurance based scheme could not work because in a crisis major borrowers and lenders could appeal for bailouts. But this criticism misses the point entirely. A public, transparent, insurance system with some kind of national government imprimatur would strengthen the ability of governments to resist pleas for bailouts. There is no way that national governments can ever completely credibly pre-commit to a particular course of action — there will always be borrowers who are "too big to fail" and there will always be large private lenders, influential in their respective national capitals. But what an insurance mechanism could do is significantly shift the presumption against bailouts in cases where transacting parties did not avail themselves of insurance opportunities.
This addresses the issue of what to do about the problem we confront, but leaves open the question of what should be done with our existing institutions. Clearly there is enormous talent in the staffs of the Bretton Woods institutions, whose missions increasingly overlap. And just as obviously there are policymakers in developing and transitional economies who labor under extreme lack of access to information — there are too many people in poor countries reinventing the wheel. Yet the development of world capital markets is such that even in the World Bank's traditional core lending business — physical infrastructure — private capital flows dwarf those generated by the multilateral development banks.
It would seem natural then, to merge the Bank and the Fund, and refocus their orientation, away from direct lending operations (with some exceptions as noted below) and instead emphasize the consulting and surveillance activities that they are uniquely positioned to pursue. One can easily imagine national governments paying for advice and training on best practices or facilitation of contact with functional counterparts in other countries. This would be an organization which would be a development institution for the information age.
Nevertheless, there will still be a role for the traditional lending operations in two specific areas. First, unfortunately, there will continue to be countries emerging from periods of physical and social devastation which will require assistance in regaining economic growth. A country like Mozambique, which has recently emerged from a protracted civil war, or the government that inherits North Korea from the regime that today is running it into the ground, will need basic reconstructive assistance of the kind that the World Bank was originally established to provide. And there are public goods, primary education is the most obvious example, in which private markets left to there own devices will underinvest. In this situation there is arguably a global rationale for assisting national governments in the provision of public goods. The point is simply that while today's Bretton Woods institutions are not optimally suited for handling today's problems, suitably reoriented, they could continue to play a positive role in tomorrow's world.
But that is tomorrow and this is today, and we have to work with the institutions as they currently exist. The IMF brings two things to the table when it negotiates with borrower governments, money and prestige. Under current conditions, it is not inconceivable that if the Fund had to initiate significant lending programs in large countries, Russia comes to mind, it could become liquidity constrained and be unable to fully execute its duties. Moreover, any perceived failure by the US to support Fund activities could due enormous damage to the Fund's ability to deal with borrowers by symbolically undercutting the organization in a time of crisis. For both of these reasons, in the immediate case in hand it is important for the US to support the IMF, flawed though it may be, while reserving the right to revisit this issue at a more propitious time.
1. For evidence on this point, see Morris Goldstein and Philip Turner, "Banking Crises in Emerging Economies: Origins and Policy Options," BIS Economic Papers, No. 49, Basle: Bank for International Settlements, October 1996, Table 1.
2. For greater explication on this point, see the statement of Marcus Noland before the House International Relations Committee Subcommittee on Asian and Pacific Affairs, 6 November 1997, downloadable from www.iie.com
3. For a more detailed development of these ideas in the Korean context, see Marcus Noland, "Restructuring Korea's Financial System for Greater Competitiveness," Working Paper Series, 96-14, Washington: Institute for International Economics; downloadable from www.iie.com
4. See Ligang Liu, Marcus Noland, Sherman Robinson, and Zhi Wang, "Asian Competitive Devaluations," Working Paper Series 98-2, Washington: Institute for International Economics. Downloadable from www.iie.com